Liquidity: When the flood subsides

Fund managers are pouring into primary bond issues because of lack of secondary liquidity. But what happens if that herd mentality remains, or even grows, when the market turns?

If the events of 2007 and 2008 taught the market anything, it is how quickly liquidity can disappear when panic sets in. Even as the credit markets wrestle with the implications of the current central bank-induced surfeit of liquidity, many are becoming increasingly concerned about how that liquidity will react when interest rates eventually rise. 

"The market was in a high state of alert about funding rates increasing in April to May and October to November last year. This gave a good idea how markets would react if surprised," says Scott Thiel, deputy chief investment officer of fixed income, fundamental portfolios, and head of European and global bonds at BlackRock. 

"The selling of positions was met with very poor liquidity. We have been in a full-blown easing cycle for the last five years. All those investment strategies that are predicated on this will be challenged when the situation...